Oran Hall | The power to make independent investment decisions
Investors can learn a lot about a company by examining and analysing its annual report.
Although it may be necessary to draw on information not contained in the annual report to calculate some ratios, such analyses help the investor to see how well the company has done historically and to make an informed determination of how it is likely to do in the future, considering developments in the company and the economy.
Companies now provide a historical statistical review of their performance over a 10-year period, generally. This allows the analyst to observe trends over that time and to come to a conclusion about the quality of the management and overall performance over the period.
These reviews go beyond providing raw data like profits by also presenting a wide range of ratios such as return on equity, dividend-payout ratio, and even price-earnings ratio at a specific date.
The investor, or prospective investor, can learn much by reading the message from the chairman and the chief executive officer about the performance of the company and the future outlook.
It is now the norm for there to be a section called Management Discussion and Analysis in the annual report to shareholders. It is quite wide in its scope, but generally, it looks at the company and its subsidiaries, if it has any services; the operating environment, including the macro economy and sector performance; financial results, including revenue by business lines and income sources; dividends; the financial condition of the company, including its assets, return on equity, shareholder’s equity, the capital of the company; and the company’s priorities and strategies for going forward.
By this means, management helps the reader to understand how well or poorly the company has done, providing the context in which it has operated and offering a look into how it will move into the future.
The many figures presented in the annual report, perhaps confusing at first, but becoming clearer with experience, help the investor to see how strong the company is and to determine whether it is worthwhile becoming or remaining a shareholder in it.
The serious investor should take a serious look at the profitability of the company and should look at the trend of the net profit and the extent to which it grows. A decline in profit in a particular year need not be a cause for alarm. Understanding the reason for the decline is important for the situation may be temporary.
Very importantly, though, the investor should look at ratios such as the return on equity and earnings per share.
The return on equity – which expresses net profit as a percentage of shareholder’s equity – tells how efficiently the company has used shareholders’ funds to generate a profit. Naturally, it is desirable for this ratio to get higher over the years.
Earnings per share says how much net profit the company makes per unit of stock. This figure – expressed in dollar terms – should also increase consistently over time.
Care should be taken, though, when interpreting this ratio as stock splits and stock bonuses – which cause the amount of shares to increase – naturally result in lower earnings per share, but not necessarily a decline of net profit. A fair comparison thus requires an adjustment to be made to reflect the change and, therefore, compare like with like.
Earnings per share provide an important component of a ratio that is dear to investors and is very closely watched by the market – the price-earnings ratio. This ratio is derived by dividing the price on any trading day by the earnings per share. Naturally, the price is not found in the annual report but in stock market reports. This ratio tells how valuable the market believes the stock is.
Although a high ratio could mean the stock is overpriced, it could also mean that the market expects the profit of the company to increase at a higher rate than that of similar companies.
A low ratio could mean that the stock is underpriced, but it could also mean that the market expects the net profit of the company to grow at a slower pace than that of similar companies.
The debt-to-equity ratio is also important as the higher ratio is the higher are the fixed charges of the company, that is, the interest on the debt and the principal, which has to be repaid at the stated maturity date. This could stifle the ability of the company to make good profits and pay dividends.
Debt itself is not necessarily bad for a company that uses it to earn more profit than what it costs, thus generating more wealth for its shareholders.
For investors invested in dividend income, the dividend payout ratio is important. Investors relate the dividend they receive to the price they pay for the stock – the dividend yield. A low dividend payout ratio is not necessarily bad as it means the company is retaining more of its profits, thus reducing its need to borrow while strengthening its financial position.
This is not an exhaustive list of the ratios that have meaning to investors, but understanding them will go a far way in helping them to develop confidence to make independent decisions.
– Oran A. Hall, author of Understanding Investments and principal author of The Handbook of Personal Financial Planning, offers personal financial planning advice and counsel.